Recently, we have increased our holdings of cash equivalents to roughly 18 percent of portfolios as our expectation for future returns on some investments no longer meet our hurdle rate. Our framework for making investment decisions includes a mechanism that we feel provides strong sell signals, not for the market but for specific portfolio holdings. In our view, this is both an important part of the investment process and has added value and downside protection for clients’ over time.
A few of our top positions are discussed below.
CF Industries is the largest nitrogen fertilizer manufacturer in the world with most of their production of Ammonia, Urea, and Uan based in Iowa and Louisiana. They currently trade for roughly 10.4 times free cash flow compared to the market which trades at over twenty times. They have a strong and, in our view, lasting cost advantage. Manufacturing fertilizer in the U.S. with cheap and abundant natural gas is much cheaper than in the rest of the world where it is made from anthracite coal in China and LNG priced off oil in Europe. Roughly 40 percent of their production costs is the cost of U.S. natural gas. According to company investor presentations, they currently have cost advantages of approximately $98 per ton compared to making fertilizer in Europe and $198 per to versus making fertilizer in China from anthracite coal. With the current ammonia prices in the Gulf Coast of about $231 per ton, this cost advantage leads to very profitable operations for U.S. fertilizer manufacturers and CF Industries in particular.
The U.S. produces roughly 85 percent of what’s required to meet domestic fertilizer demand, so we are still dependent on imports for 15 percent of our needs. That means U.S. fertilizer prices need to be high enough to compensate higher cost producers around the world to make and ship their product to the U.S. Gulf Coast. Additional costs are required to get the product up the Mississippi river into the farm belt. Particularly with their Iowa production, CF Industries doesn’t bear these costs to get fertilizer to customers. These cost advantages could be enhanced if increased U.S. oil shale production is needed to meet world demand due to supply disruptions in the Middle East. This could further lower the price of natural gas in the U.S. further compared to European gas costs and Chinese coal costs since 50 percent of gas production in the U.S. is associated with drilling for oil. In other words, major U.S. oil producers aren’t that worried about creating excess supply of natural gas and driving down prices, since these projects are economically justified by oil revenues alone.
Berkshire Hathaway, despite having a market value around $500 billion, is little followed and not well understood by Wall Street which largely explains their current undervaluation in our view. The investment community seems to think of Berkshire as a fund dependent on 89-year-old Warren Buffett’s latest stock pick. Instead, we think it should be valued and viewed largely as a group of fully owned well and well positioned companies including many industrial companies, the largest being Burlington Northern and Precision Castparts.
In addition, they have the world’s largest insurance business with strong business advantages derived from their enormous capital position and a long- term view with little regard for quarterly mark to market volatility. Put together, this gives them the ability to make quick decision and means they are often the only company willing to write large and unusual risks. Their insurance business also includes full ownership of Geico, the leading auto insurance company. The large and growing float from their insurance business is very valuable in that it’s like borrowing money at a negative rate because of their underwriting profitability which can be invested for the long term in common stocks because of how much excess capital they have accumulated to pay potential claims.
Accounting quirks cause their earnings to be understated since they are required to reflect dividends alone on their income statement if they own less than 20 percent of a company. In our view, this significantly understates their true earnings power. As an example, if a company they own in their $150 billion+ stock portfolio only pays out 1/3 of earnings as a dividend then their income statement only reflects 1/3 of their share of that company’s earnings. Our estimate of their earnings adjusting for that and excluding amortization of intangibles from acquisitions, results in Berkshire amalgamation of strong businesses trading for just 14 times our estimate of next year’s earnings. Adjusting for their $100 billion in excess cash, which would come in handy in any market downturn, they trade for just 12 times our estimate of next year’s earnings.
Our worst five and best five performing positions year to date through September 30, 2019 are outlined below.
Worst 5 Positions Best 5 Positions
Fox Class A (20.8%) Moody’s 47.9%
Delta Air Lines (1.5%) Apple 43.7%
Berkshire Hathaway 1.9% Lennar B 41.4%
United Technologies 9.2% Carmax 40.3%
Liberty Media Sirius 10.1% Home Depot 38.1%
Please feel free to contact us at 910-763-4113 if you would like further information about our company.
PAST RESULTS ARE NOT INDICATIVE OF FUTURE RETURNS
Mr. Nowell has over thirty years of experience in the finance business. Prior to founding South Atlantic Capital he worked in the leveraged lending department of Bankers Trust Company, New York as an Assistant Vice President. His primary responsibility was arranging bank financing for leveraged buyouts led by Kohlberg, Kravis, Roberts & Company. During graduate school he interned with Merrill Lynch’s Capital Markets Group in New York. Later he served as an institutional fixed income salesman for Carolina Securities/Prudential Bache Securities and worked with Fox, Graham, and Mintz Securities. Mr. Nowell graduated from the University of North Carolina with a B.S. in Economics and received his MBA from the University of Virginia.
Rob Kaiser - Jun 1, 2020
Staff Reports - Jun 1, 2020
Cece Nunn - Jun 1, 2020
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